Short selling is harder than you think

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Short selling has been a hot topic after a noted US-based short seller released a negative report about listed fund manager Blue Sky Limited (ASX:BLA). This caused Blue Sky’s share price to fall 50%, wiping $440 million from its market cap. Short sellers are frequently derided as vultures, rumour mongers or even ‘unAustralian’. However, in practice, shorting stocks is a difficult, stressful and lonely way to make money in a market which is predominately skewed towards good news and wearers of rose-tinted glasses.

This article does not look at the merits of Blue Sky as an investment, but rather at the mechanics and issues around short selling equities. Much of the recent coverage on short selling reveals that many of those who hold strident opinions on short selling have only a limited understanding of how it actually works.

Step one:  Find a company with bad characteristics and a catalyst

In traditional long only investing, the goal is to own good quality companies with honest management teams, clean balance sheets and solid future prospects. By contrast, the desirable characteristics of a short sell include companies with low or negative growth, high and increasing debt levels, a weak business model, overvaluation by a market, and possessing a shaky management team. However, a critical factor is the requirement for a catalyst: overvaluation or high debt in itself is rarely enough. In Blue Sky’s case, it was the negative report from Glaucus. As very few investors have the luxury of lobbing a damming report from the sidelines and outside the regulation of ASIC and the ASX, we would normally look for events such as a potentially bad acquisition (preferably off-shore), heavy directors selling, or corporate turnover at management level.

Step two: Find the stock to borrow

Short sellers will then borrow stock from a stockbroker and sell it. They are essentially betting that the price of the target company will decline before they have to replace the borrowed shares by buying the stock back. This is often the step that is ignored in the financial press when talking about shorting a company’s stock, as it is wrongly assumed that investors can easily borrow stock to reflect their negative view on a company.

When borrowing shares to short sell, an investor has to look closely at both the rate per annum that they are required to pay to borrow the stock, and where the owner is located geographically. The rate reflects supply and demand, and for most stocks is currently 0.5% per annum. For stocks where the shorting demand may be higher than the supply (such as Fortescue) the rate may be 15% or higher. In the case of small capitalisation or tightly held companies such as Blackmores, the short seller may be unable to borrow stock and thus cannot short sell. Obviously a high cost to borrow stock to sell short imposes a return hurdle on the would be short-seller.

In the case of Blue Sky, when we looked a week ago there was no stock available to be borrowed and the current short-sold position only represents 2.6 million shares, or 3.3% of the register and over the course of this week this has been reduced by 1 million shares as short sellers have closed their positions, buying back Blue Sky stock.

In a small and tightly held company such as Blue Sky, most holders would not lend out their stock for short selling as to do so they would be providing short sellers with the ammunition to bet against their long position. For example, BigUN – which was suspended from the ASX in February 2018 due to accounting irregularities – only had 500,000 shares lent out to short sellers, which is a mere 0.3% of the register. In the lead up to BigUN’s suspension as its share price was falling, the demand to short this stock would have been intense, but there would have been no stock available to be borrowed.

Step three: Watch for dividends and corporate actions

The short seller is required both to return the shares to the owner when requested, and also to pass on any dividends paid. We also strongly prefer to borrow stock from foreign owners such as large index funds like Vanguard or State Street, as if you borrow stock from a domestic owner and a dividend is paid, short sellers are required to compensate the original owner for both the dividend and any associated franking credits.

What happens if the stock goes up?

If the short stock rises sharply, the lender will be required to give their broker additional collateral, or the broker will require the short seller to close out the short sale transaction before the planned timeframe. A series of urgent requests to wire cash to your margin account to cover a short-sold stock that is rising sharply will test the mettle of even the most hardened short seller. In contrast, a long only position in a falling company can mentally be filed in one’s bottom drawer until it eventually comes good (or goes into administration).

This gives rise to the skewed payoff ratio from short selling, where the maximum gain is known (the stock falls to zero), but the maximum loss is theoretically infinite. Also, when a short position goes bad because the stock price rises, it becomes a larger part of the portfolio, and from a portfolio risk management perspective, there may be additional pressure to trim the position, which contributes to the short squeeze (defined below).

The market can remain wrong longer than you can remain solvent

It would be wrong to view that short selling risky stocks is a smooth path to outperformance. Keynes, the father of modern macroeconomics, once famously said that “markets can remain irrational longer than you can remain solvent’’. This quote particularly resonated with me after an unprofitable short selling of Fortescue prior to the GFC due to concerns about the overvaluation and debt situation of the company.

This trade was put on at $50 per share late 2007 and then was closed out at $70 four months later as the price continued to rise with no signs of slowing momentum. It was very painful to lose 29% in a short stretch of time; however, Fortescue peaked at $120 in June 2008 before falling back to $20 in December 2008. Whilst our investment thesis was ultimately correct, we were unable to handle the pain of a steeply rising stock and the associated unrealised losses and increasing margin calls.

What’s a short squeeze?

A ‘short squeeze’ occurs when a heavily-shorted stock rises sharply, forcing sellers to close out their position by buying back stock, thus causing further upward price momentum. Often when the market appears to overreact to a small piece of positive news, this is a short squeeze and it is similar to too many people trying to fit through a door.

For example, if JB-Hi Fi (currently 17% of the register has been ‘borrowed’ by short sellers anticipating that the price will go down) or Domino’s Pizza (18% short) were to receive a takeover bid, the price would escalate sharply as short sellers look to cover their positions. A nightmare scenario would be a contested bidding war if you are short. In December 2017 we saw a short squeeze in Westfield when a bid from Unibail-Rodamco came through. However, unlike Dominos or JB Hi-Fi, the percentage of the property trust’s outstanding shares that we sold short was not a large amount, though we did see a spike in the share price that reflected the short sellers buying back stock to exit their positions.

Short selling is not easy and does not deserve its poor reputation

While short selling is often criticised and retains a negative connotation in a securities industry that is inherently biased towards optimism, it serves a valid role in financial markets. Short sellers provide an alternative view and can aid both liquidity and price discovery. In coming years, especially with MiFID II (new European regulations on stockbrokers) reducing the incentives for the investment banks to put out sell side research, shorting will provide an alternative view. At the moment, it’s no surprise that 80% of calls are buy or hold!

Investors should not look at situations like Blue Sky, BigUn or Slater and Gordon and view that it is an easy way to make money, nor that it is unfairly ganging up on a company. Even experienced and adept short sellers such as Glaucus make expensive mistakes. For example, its shorts on Japanese trading house Itochu would have cost the fund manager substantially, with Itochu’s share price up +43% since Glaucus released a report in mid-2016. The same could still happen with Blue Sky.

 

Hugh Dive CFA is Chief Investment Officer at Atlas Funds Management. Neither the Atlas High Income Property Fund nor the Maxim Atlas Core Australian Equity Portfolio employ shorting as an investment strategy. However, the author has previously managed a long-short fund. This article does not consider the circumstances of any individual.

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3 Responses to Short selling is harder than you think

  1. Fundie April 15, 2018 at 4:40 PM #

    Glaucus does have an advantage of not being subject to local regulations, and Blue Sky was ripe for criticism with its valuation methods and a fair amount of hubris about its share price and portfolio.

  2. Andrew Brown April 16, 2018 at 2:04 PM #

    Nice piece Hugh. I do disagree about the valuation shorts but that’s subjective not objective. Blue Sky had all sorts of issues but I was amazed it took a Glaucus to unravel it. One factor you omitted in the borrowing aspect was the ability/propensity of an active fund lender to call their stock back in, meaning as a short you get bought in at any old price. That certainly happened in Blue Sky at various stages, and then in recent days as active holders wanted to sell and needed their shares back.

  3. HughD April 19, 2018 at 3:24 PM #

    Thanks Andrew, good point about getting the stock called back. This is why most short sellers will prefer to use “GC” or General Collateral stocks, as the source of the borrow is usually the large global index funds such as BlackRock or State Street. Certainly in spicier names such as BLA or even DMP you run the risk of getting your stock called back and having trouble trying to replace it. The reason why it is usually tough to find borrow in the smaller names as it doesn’t make much sense for a small cap fund manager who has a long position in a company to lend out their stock for what may be less than 1% per annum (after the investment bank have taken their cut).

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